Newcrest and the hidden cost of weak R.O.E.

The normalised return on equity of listed companies is at recessionary levels.

Summary:The capital productivity of Australia’s listed companies is poor, with normalised return on equity tracking at levels last seen in the 1992-93 recession. This poor performance has occurred in an economy that has grown by 3% per annum over the last five years.

Key take-out: One example is Newcrest Mining, which last week disclosed it was achieving a totally inadequate NROE.

Key beneficiaries:General investors.Category: Growth.

Much is written, and there is a continuing debate, regarding Australia’s productivity performance. In doing so, there is a proper focus on the output of labour.

In particular, there is much analysis on the output per man-hour and the cost of that output. This is absolutely important information to help analyse the relative performance of Australia in a world trade or economic performance context.

However, what is less well analysed but arguably just as important to our future well-being, is the productivity of Australia’s capital. While there is an enormous proportion of our nation’s retirement savings or “capital” being directed into major Australian companies, we see scant analysis of the actual returns that it generates.

Even worse is that the business leaders of Australia don’t tell you how they are performing with your capital. In my view, their collective performance with Australia’s capital base is appalling. As Alan Kohler put it recently, (The System is Rigged). In other words, they (business leaders) are doing far less, with far more capital. And ROE eventually turns into investment performance, but it usually doesn’t affect the bonuses of the executives. It’s in their interests to raise capital. Today I want to show you a startling example of this practice in progress.

The following chart shows this clearly. The chart tracks the “normalised” return on equity (NROE) of the companies listed on the Australian sharemarket. The normalisation of the ROE involves the addition of the franking credits that are paid to shareholders from dividends.

The table shows that the current NROE is tracking at levels last seen in the “recession we had to have” of 1992-93. This is a national embarrassment as it has been achieved in an economy that has grown by 3% per annum over the last five years. Further, and to the benefit of returns, this was also a period when our terms of trade were at historic high levels.

The rapid decline in NROE from 2007 to 2013 can be put into context as follows:

The period 2003 to 2007 was a period of excessive leverage in the Australian corporate sector. Debt was aggressively used in a period where Australia, like the US, had a debt-fuelled consumption binge. During that period the high reported NROE was the result of leverage that enhanced reported business performance;

The GFC and the fear of an economic downturn caused a complete reassessment across the equity market of the appropriate level of debt; and

As a result, many companies rushed to the equity market to raise capital to retire debt. The result was that this incremental equity generated an interest return well below the normal required return on equity. The provision of capital at that time by institutional investors was undisciplined, poorly structured and with little regard to value.

The spike in the amount of capital raised in 2008 and 2009 is clearly shown below and the subsequent drop in NROE was shown earlier. The current level of the stockmarket index, which resides at levels seen in 2006 (4,850 points), is thus explained by the rapidly declining NROE.

An example of mediocrity - Newcrest Mining (ASX:NCM)

The above general analysis of Australia’s poor capital productivity was specifically on display last week when Newcrest Mining disclosed what had been actually apparent for years – it was achieving a totally inadequate NROE.

At the outset, let me state that I do not understand the reasoning of an investor in owning a listed gold production and exploration company as a means to generate long-term wealth. The commercial logic of owning a business that must dig up immense amounts of dirt to produce small amounts of metal, for a market price that no-one can explain, seems to me to be a difficult concept to support. Then, to rub dirt into the wound, the company must retain earnings to undertake more exploration. The cash flow, so to speak, goes back into the ground, through exorbitantly paid executives advised by investment banks, who feed on the requirement for capital replenishment.

A logical owner of a gold mine would demand his risk capital back as soon as possible because the market risk is high, the production risk is high, and a developed mine has a finite life. Large dividends are essential, but are rarely on offer in the listed gold market.

As you can see from the chart below from “stocksinvalue.com.au”, the last five years of NCM have been diabolical for investors. Last week’s downgrade in the value of NCM’s assets was absolutely predictable based on the consistent poor financial performance of the business.

In particular I draw your attention to the following financial “low lights” on NCM:

Equity has lifted over five years from $3.2 billion to $15 billion on a pre-write-down basis. Of this $11.8 billion lift, some $10.8 billion came from new capital raised for acquisitions and to close hedging contracts;

Over the five years the cash profit per annum only lifted from $248 million to about $780 million, despite the massive lift in capital;

The incremental return on the increased equity was a pathetic 5% per annum; and

The dividends paid to shareholders of $1 billion over the last five years have all been unfranked.

So shareholders who meekly watched NCM management woefully invest $10 billion now are witnessing the judgement of the market. The share price has plummeted by 60% in just six months.

But how did it ever get to $30 in October 2012 and over $40 in 2011? The broking analysts who suddenly came to a unanimous decision to downgrade together had all previously agreed that it was a wonderful stock – but what else would a gold analyst say? I always claimed it was massively overvalued, and still do today.

Growth portfolio adjustments

As I mentioned a few weeks back, I have taken both Flight Centre (FLT) and Iress (IRE) out of the portfolio, effective from the close of trade on May 30. Currently the portfolio is sitting with just nine positions and about 30% cash.

The coming reporting season will certainly confirm that trading conditions in the Australian economy are difficult. The market has fallen back towards fair value, and I am looking for a few additions to the portfolio. However, as I mentioned above, the performance of listed Australian corporations leaves a lot to be desired and the pickings are slim at present.

John Abernethy is the Chief investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Managemen,t visit their website at www.clime.com.au

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